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The SIJ Transactions on Industrial, Financial & Business Management (IFBM), Vol. 2, No.

6, August 2014
ISSN: 2321-242X 2014 | Published by The Standard International Journals (The SIJ) 273

AbstractEfficient Market Theory has been the single and controlling theory of portfolio management for
many years. But the Behavioural Finance discipline has challenged the assumptions of Efficient Market
Hypothesis, particularly the investor rationality concept. It has incorporated emotion and psychology too into
investment behaviour study. However review of earlier studies shown that very few studies are available
focusing on specific contradictions between the two disciplines in detail. So an attempt has been made in this
paper to focus on the contradictions between Efficient Market Hypothesis and Behavioural Finance in detail
with an endeavor to arrive at a conclusion, which one is better. The study is mainly conceptual and descriptive
in nature and is based on the studies available over internet based sources and various other related books and
journals. The major finding the study is that there are definite shortcomings of EMH as pointed out by the
Behavioural Finance, but at the same it is also to be noted that as a theoretical framework, it is definitely a
modest attempt and it has many positive sides in the context of stock market study but it needs more
refinement and more rigorous analysis to replace a far impacted theory like EMH.
KeywordsBehavioural Finance; Contradiction; Efficient Market Hypothesis; Investment Behaviour;
AbbreviationsEfficient Market Hypothesis (EMH).

FFICIENT Market Hypothesis is one of the most
accepted financial market theories.The efficient
market hypothesis became one of the most influential
concepts of modern economics and a cornerstone of financial
economics. It was extended in many directions, and literally
thousands of papers were written about it [Alajbeg Denis et
al., 2012]. Although being central to the modern portfolio
management theories it also has got many criticisms from the
scholars. The Efficient Market Hypothesis is considered as
the backbone of contemporary financial theory and has been
the dominant investing theory for more than 30 years (from
the early 60s to the mid 90s). Needless to say, a generation
ago, it was the most widely accepted approach by academic
financial economists [Konstantinidis et al., 2012]. Thus the
theory assumed to be in the superlative position right from its
inception to the end of 1990s. But after 1990s various
anomalies have been identified and the concept was criticized
on many grounds. Such criticisms have given birth to an
alternative discipline called Behavioural Finance. This new
domain has challenged the assumptions of EMH, particularly
the investor rationality concept by incorporating emotion and
psychology too in the investment behaviour study. Although
many studies are available regarding the principles of both
the disciplines, but studies which have specifically and
analytically pointed out the contradictions between them in
detail are very few. So in this paper an attempt has been made
to make a detail analysis of the contradictory points rather
than discussing the principles only. Although the study is
mainly based on the previous studies but a systematic and
specific analysis has been attempted here. The present study
would definitely help to understand not only the principles of
the two domains but at the same time would assist to arrive at
a conclusion which one is better in the context of financial
market study.
The Efficient Market Hypothesis and Behavioural finance are
two main but seeming contradictory domains for study of
securities market behaviour. Both the concepts have been
studied and supported by different authors all over the world.
However in spite of this still there exists debate over their
individual effectiveness. In this paper an attempt has been
made to make an analysis of both the concepts and also to
arrive at a conclusion about which one is the best.
*Assistant Professor, Department of Commerce, Naharkatiya College, Naharkatia-786610, Dibrugarh, Assam, INDIA.
E-Mail: amlanjsharma{at}gmail{dot}com
Amlan Jyoti Sharma*
The Behavioural Finance:
A Challenge or Replacement to Efficient
Market Concept
The SIJ Transactions on Industrial, Financial & Business Management (IFBM), Vol. 2, No. 6, August 2014
ISSN: 2321-242X 2014 | Published by The Standard International Journals (The SIJ) 274
The paper is mainly conceptual and descriptive in nature and
it is based on the studies available over internet based sources
and various other related books and journals.
As the name implies it tells about how efficient the market is?
The efficiency in terms of analyzing and interpreting the
financial information relating either directly or indirectly to
the investment decisions. An efficient market is defined as a
market where there are large numbers of rational profit
maximizers actively competing, with each trying to predict
future market values of individual securities, and where
important current information is almost freely available to all
participants [Fama, 1965]. Thus changes in asset prices can
be treated as a function of the flow of new information to the
A good definition of market efficiency was given by
Malkiel (1992). According to him a capital market is said to
be efficient if it fully and correctly reflects all relevant
information in determining security prices. Formally, the
market is said to be efficient with respect to some information
if security prices would be unaffected by revealing that
information to all participants. Moreover, efficiency with
respect to an information set,
, implies that it is impossible
to make economic profits by trading on the basis of
There are three forms of market efficiency as said by
different scholars in the area of finance. They are weak form,
semi strong form and the strong form of efficiency. In its
weak form all the past information are reflected in stock
prices and no one can have an edge by analyzing the past
trends or any other past information i.e. technical analysis
will be useless. However, one can beat the market and get
abnormal returns on the basis of fundamental analysis or on
the basis of private information (insider trading).In its semi
strong form it includes the public information with the past
information as mentioned under weak form. It means both
past and present information which is publicly available is
used and interpreted by all the investors in the same way and
as a result both technical and fundamental analysis will be
useless. However by insider trading one can outperform the
market. But in the strong form along with the public and past
information the private information available generally to the
insiders are also useless to produce higher returns. In its
strong form it is impossible to beat the market by any means.
Thus in an efficient market to pick up the best stock and to
have higher returns on the basis of information is not possible
at all and if it happens then it would be due to blind luck
only. Temptating advertisements of the past results or the
reputation of fund managers is nothing to do with the future
position of the stock, as no one can outperform the market
and the stock prices already reflect all public and private
Efficient market concept deals with the information and how
the informational accuracy affects the stock market. But the
behavioural finance dimensions deal with the market
participants behaviour not only on the basis of information
but also several other emotional and psychological
dimensions. It is the behaviour of the market participants
which shapes the ultimate stock market structure. So an in
depth study of the behaviour is felt necessary and this job is
undertaken by the behavioural finance discipline. One of the
main assumptions of the efficient market hypothesis is the
investor rationality, which means the investors are always
rational while making investment decisions in the stock
market. But the behavioural finance says that the investors
decision making process is not only based on rational
analysis always. Rather they are forced to be the prey of
different emotional and psychological attitudes which
contradicts rational behaviour. So the studies of these
emotional factors are also necessary to analyse the investor
History of the behavioural finance goes back to Herbert
A Simon, the Nobel lieutenant of 1978, for his paper in 1955
A behavioural model of rational choice may be regarded as
the first thought that endevoured to state about a new concept
called behavioural finance [Simon, 1955]. According to
Kannadhassan (2006) in the present scenario, behavioural
finance is becoming an integral part of the decision-making
process, because it heavily influences investors performance.
They can improve their performance by recognizing the
biases and errors of judgment to which all of us are prone.
Understanding the behavioural finance will help the investors
to select a better investment instrument and they can avoid
repeating the expensive errors in future. The pertinent issues
of this analytical study are how to minimize or eliminate the
psychological biases in investment decision process.
The systematic study of behavioural finance started
actually from the work of Daniel Kahneman & Amos
Tversky (1973) where they for the first time discussed about
the different heuristics affecting investment decisions. They
also founded the very famous Prospect Theory in Tversky &
Kahneman (1979) where they found that individuals will
respond differently to equivalent situations depending on
whether it is presented in the context of losses or gains and
found that individuals are much more distressed by
prospective losses than they are happy by equivalent gains.
Statman Meir (2009), a professor from Santa Clara
University wrote in an article published in the Wall Street
Journal that most investors were intelligent people, neither
irrational nor insane. But behavioural finance tells us we are
also normal, with brains that are often full and emotions that
are often overflowing and that means we are normal smart at
times, and normal stupid at others.

The SIJ Transactions on Industrial, Financial & Business Management (IFBM), Vol. 2, No. 6, August 2014
ISSN: 2321-242X 2014 | Published by The Standard International Journals (The SIJ) 275
The main grounds of contradiction between the two concepts
of investment theories may be stated as under:
6.1. Rationality Concept
The main contradiction between the two is on the ground of
investor rationality. Efficient market concept is based on the
concept of rational investor behaviour, i.e. the investors
always behave in a rational way. According to Rohit Kishore
(2006) Traditional finance theorists believe that, any
mispricing created by irrational traders (noise traders) in the
marketplace, will create an attractive opportunity which will
be quickly capitalized on by the rational traders (arbitrageurs)
and the mispricing will be corrected. Rationality means two
things. First, when they receive new information, agents
update their beliefs correctly, in the manner described by
Bayes law. Second, given their beliefs, agents make choices
that are normatively acceptable, in the sense that they are
consistent with Savages notion of Subjective Expected
Utility [Nicholas Barberis & Richard Thaler, 2003]. They
always make the best and proper use of the information they
possess and analyses in an objective manner. But many
studies have shown that in most of the times the investors
being the social beings, with a brain and a heart full of
emotions, behave in an irrational way, in spite of having
different important information. They just overlook the
rationality attitude and become biased in many cases.
Behavioural finance is a new approach to financial markets
that has emerged, at least in part, in response to the
difficulties faced by the traditional paradigm. In broad terms,
it argues that some financial phenomena can be better
understood using models in which some agents are not fully
rational [Nicholas Barberis & Richard Thaler, 2003].
6.2. Emotional I nvesting
Most investors are intelligent people, neither irrational nor
insane. But behavioural finance tells us we are also normal,
with brains that are often full and emotions that are often
overflowing. And that means we are normal smart at times,
and normal stupid at others [Statman Meir, 2009]. But there
is no place of such emotions in rational investment decisions.
The efficient market theory arguments that investors are
rational i.e. their investment decisions are made according to
their risk aversion, which is measured by the mean and
variance of the returns. However according to Michael
Pompian (2006) rationality is not the sole driver of human
behaviour. In fact, it may not even be the primary driver, as
many psychologists believe that the human intellect is
actually subservient to human emotion. They contend,
therefore, that human behaviour is less the product of logic
than of subjective impulses, such as fear, love, hate, pleasure,
and pain. Humans use their intellect only to achieve or to
avoid these emotional outcomes. Over the last 25 years,
scholars began to discover empirical results that were not
consistent with the view that market returns were determined
in accordance with the efficient market theory. Additionally,
empirical research shows that, when selecting a portfolio,
portfolio managers not only consider statistical measures
such as risk and return, but also psychological factors such as
sentiment, overconfidence, overreaction, etc. As these factors
begun to be identified by scholars, a new school of thought
began to emerge; that of Behavioural Finance [Aguila Natalia
del, 2009].
6.3. I nformation based Concept
Efficient market hypothesis whether in weak, semi strong or
strong form all are based on the concept of use of information
only without considering other factors. The EMH says that
financial markets are informationally efficient although in
different forms i.e. weak, semi-strong, and strong form. But
the behavioural finance concept is not only based on the
information but also it covers different other factors related to
human psychology and cognitive and emotional factors
which definitely affects the investment decisions.
6.4. I nformational Accuracy
Efficient market concept always believes that the investors
have access to all information and stock prices reflect that
information instantly. But in practice, this may not be
possible always because all the investors may not have access
to all information at the same time. In the world of
investing, there is nearly an infinite amount to know and
learn; and even the most successful investors dont master all
disciplines [Michael Pompian, 2006]. As a result stock
prices may not reflect always the true picture of informational
analysis by the investors. The presence of noise traders is an
example to prove this.
6.5. Demographic Factors
In an efficient market there is no difference between a new
and an experienced investor and all are treated as equally
rational, equally specialised while making investment
decisions. But behavioural finance says that the demographic
factors like, age, sex, education, income level etc. all are
having different effects on investors behaviour. In fact an
experienced investor may make a better decision than a nave
investor. Even the cultures, personality etc.these all are also
have binding effect on investment decisions. Wang & Hanna,
(1997) found that relative risk aversion decreased with the
increase in age. Similarly Farrell James found that women, in
general, were shown to take less risk than men.
6.6. I nterdisciplinary grounds:
Efficient market hypothesis is mainly based the concepts of
economics only, like perfect market concept or expected
utility theory etc., but behavioural finance is an
multidisciplinary subject which has borrowed different
concepts of human behaviour from other disciplines like,
sociology, psychology etc. to best study the human behaviour
in respect to investment world. Victor Ricciardi & Helen K
Simon (2000) has rightly said that when studying concepts of
behavioural finance, traditional finance is still the
centerpiece; however, the behavioural aspects of psychology
The SIJ Transactions on Industrial, Financial & Business Management (IFBM), Vol. 2, No. 6, August 2014
ISSN: 2321-242X 2014 | Published by The Standard International Journals (The SIJ) 276
and sociology are integral catalysts within this field of study.
According to Rohit Kishore (2006), It utilizes knowledge of
cognitive psychology, social sciences and anthropology to
explain irrational investor behaviour that is not being
captured by the traditional rational based models. Therefore
the person studying behavioural finance must have a basic
understanding of the concepts of psychology, sociology, and
finance to become acquainted with overall concepts of
behavioural finance.
6.7. Market Bubbles and Market Crisis:
Had the financial markets been really efficient, the different
financial crisis or the investment bubbles might not have
occurred as according to EMH a big positive or negative
move of the stock prices is caused only by the good or bad
news about the future prospects of the company. But
behavioural finance postulates that the investors were not
always acted as rational as predicted by the efficient market
concept. So there is definitely something which is missing to
better judge the investors behaviour. Behavioural finance is
also not an end to it, but definitely one step forward on this
direction to better understand the investors by studying their
behaviour from different other angles and to study the
bubbles and crashes. Behavioural finance says that such crisis
or bubbles are the result of investor irrationality.
Summary of Contradictions
Basis Efficient Market Hypothesis Behavioural Finance
I nvestor
EMH presumes that investors in the financial market are
always rational in respect of analysis of information and
decision making.
Behavioural Finance discipline says that investors are not
always rational. Most of the times their behaviour shows
Role of Emotions
There is no place for emotions in decision making
process as per EMH.
Behavioral finance has incorporated emotion and
psychology too in the investment behaviour study.
I nformational
Strong form of EMH says that all the investors have
equal access to all information and the stock price
reflects that information and as such the prices happen to
be informationally accurate.
Behavioural finance denies the equal access to information
principle of EMH and says that stock prices do not always
reflect all information.
EMH does not make any distinction between a new and
experienced investor.
Behavioural Finance makes distinction between investors as
per age, sex, income, education level, experience etc.
I nterdisciplinary
EMH is mainly based on the principles of Economics.
Behavioural Finance includes the theories of psychology,
sociology and also other disciplines too in some cases.
Market Crisis
Had the EMH actually been exist, there would not have
found any market crisis or market bubbles, as EMH
believes that the investors always act rationally.
The market crisis or bubbles are better described by
Behavioural finance saying that in decision making process
the investor rationality is not the only ground and various
other issues should also to be analysed.

From the above analysis we see that there are definitely
different shortcomings of EMH, as all the good theories have.
The theory has been tested many times at different situations
leading to conclusions sometimes favorable to it and vice
versa. Those shortcomings actually are pointed out by the
behavioural finance dimensions, specially the investor
rationality concept. We cannot say that behavioural finance is
an original development in nature, because it must lend its
back to the EMH and other traditional portfolio models. Due
to the shortcomings of those theories and models a new
outlook was necessitated and behavioural finance is one such
idea. As Subash Rahul (2012) pointed out in his thesis The
science does not try to label traditional financial theories as
obsolete, but seeks to supplement the theories by relaxing on
its assumptions on rationality and taking into consideration
the premise that human behaviour can be understood better if
the effects of cognitive and psychological biases could be
studied in context where decisions are made. There is no
doubt that investors being the human beings must be affected
by emotions and individual psychological foundations. If the
investor rationality concept of the EMH is refined and
thereby adding the elements of behavioural finance too, will
definitely lead to a good new development to define the stock
market anomalies. However the behavioural finance alone
cannot be said to be a perfect one because the discipline is not
too old to accept as a theory. And the behavioural finance is
only a collection of ideas and thoughts which are descriptive
and advisory in nature but they are not exhaustive. More
discussions and studies are required to point the limitations of
behavioural finance itself so as to refine it to be a good
theory. Till then we must admit that it is a theoretical
framework, which is definitely a modest attempt and it has
many positive sides in the context of stock market study but it
needs more refinement and more rigorous analysis to replace
a far impacted theory like EMH.
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ISSN: 2321-242X 2014 | Published by The Standard International Journals (The SIJ) 277
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Amlan Jyoti Sharma. He earned his Masters
Degree in Commerce from Dibrugarh
University, Assam, India and has been acting
as an Assistant Professor in the Department
of Commerce, at Naharkatiya College,
Dibrugarh since 2008. His areas of interests
are Accountancy, Behavioural Finance,
Investment Behaviour, and Capital Market.
He has published three papers in national and
international journals and attended four seminars in various subjects.
He is currently pursuing his Ph.D. on a topic related to investment
behaviour under Assam University, Silchar.